Phew. That was close.
The US narrowly avoided a government shutdown this weekend.
After much wrangling in Congress, the Republicans and the Democrats managed to agree a deal on spending cuts. So the government stays open – for now.
But there’s a much bigger fight to come.
And the end result could have a major impact on investors around the globe…
The biggest fight over US spending is yet to come
On Saturday morning, in the US, the Democrats and Republicans managed to strike a deal to avoid a government shutdown. They compromised by agreeing to cut about $38bn from spending plans for the year to 30 September.
A government shutdown isn’t quite as dramatic as it sounds. It’s happened in the past – you can read all about it in this piece by my colleague James McKeigue here: What happens if the US government shuts down?
But this is far from the final battle. That’s still to come. The US is only months – possibly weeks – away from slamming into its ‘debt ceiling’. The debt ceiling puts a cap on how high total US government debt can go before those in power say enough is enough. At the moment, it’s sitting at $14.3 trillion.
Government debt is on course to hit that level by 16 May, reckons the US Treasury department. After that, says Bloomberg, it can use various accounting fiddles to “stave off default”. But by 8 July, “it will be out of options”.
How did the US end up with this level of debt in the first place, you ask? Well, the debt ceiling is often a formality – increases are rubber-stamped, and the borrowing and spending binge continues.
Not this time. The Republicans control the House of Representatives, so the Democrats have to hammer out a deal with them to start cutting debt in the long run. And this time, the Republicans want to see some serious cuts. We’re talking trillions, rather than billions of dollars.
“I can tell you this: there will not be an increase in the debt limit without something really, really big attached to it”, said House Speaker John Boehner, a Republican, according to Bloomberg.
Why does the debt ceiling matter?
To put it simply, the US can’t borrow any more money once it reaches it. And if it can’t borrow more money, it’ll either have to slash spending, or stiff its creditors.
Now the latter is very unlikely to happen – it really would be a global economic disaster if the US defaulted on its debt. It’s not like the debt ceiling is hit, and the US immediately defaults and shuts down. The US would still be able to pay interest on its government bonds (Treasuries).
As James McDonald pointed out to Felix Salmon at Reuters earlier this year, the government can “temporarily cut back, or delay, its expenses”. Interest payments of $16bn a month, only amount to “5% of spending”, so they should be easy enough to find.
But there are other potential problems, says McDonald. Given that the annual budget deficit (how much the government’s spending outstrips tax revenue each year) is around $1.5 trillion, the US is currently having to issue debt at a rate of $130bn a month. That’s a much bigger sum to have to cut back or delay.
So failure to reach a deal would be bad news. And that’s why the debt ceiling is almost certain to be raised. It’s just a question of how much brinksmanship there will be. The more wrangling there is, the less confident investors will become in the state of the US political process, and the more chance there is that the rates the US has to pay to borrow will rise (ie the price of Treasuries will fall).
But any austerity package could result in higher inflation in the US anyway.
How US spending cuts could push inflation higher
Here’s why. In Britain, there’s an implicit understanding between the government and the Bank of England (BoE). The government’s spending cuts are being made against a very forgiving monetary policy backdrop. So BoE governor Mervyn King keeps interest rates low, which gives the economy a bit of a cushion while the government slashes back its spending.
That’s not to say that the BoE won’t be forced to raise rates, or that there’s some sort of dodgy dealing going on here. But King appreciates that with spending being cut, there’s more risk of a recession, and that’s why he keeps monetary policy slack.
The situation in the US is very similar to our own, although more extreme. They have a highly indebted government that needs to cut back on its spending if it wants to preserve its long-term credibility. They also have a burgeoning inflation problem that the central bank is reluctant to acknowledge, because for now it’s more afraid of driving the economy into a double-dip than it is of rising prices.
So if the price of getting the debt ceiling raised is for the US government to introduce hefty spending cuts, that will make Fed chief Ben Bernanke even more determined to keep going with the current batch of quantitative easing (QE2) and to prime the pump for QE3. That would add even more inflationary pressure to the mix, pushing commodity prices ever higher.
What does it mean for investors? There are plenty of implications, but a couple spring to mind immediately. For one thing, this upheaval over the US government’s finances is yet another reason why gold has been doing so well recently. The yellow metal should continue to be a good investment while uncertainty remains. And even although a rise in the debt ceiling and the promise of more QE may seem like good news in the short term, in the long run more money printing and more debt are just further reasons to buy gold.
Another is that the time could be approaching to short US government debt (rising inflation is generally bad for bonds). Bill Gross, head of the world’s biggest bond fund at Pimco, sold out of US Treasuries altogether earlier this year, and last month was actually shorting them, reports Bloomberg.
Of course, if a further bout of QE is announced, involving buying Treasuries, then they could rebound. So timing this market is very difficult. But you don’t have to. Last year, my colleague Simon Caufield looked at a ‘buy and hold’ method of shorting US government bonds without having to time the market – you can read his piece here: How to short government bonds.
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